Between extremes: Trading with channels

Channels are an important technical condition prevalent on almost all price charts on all time frames. Traders use these simple formations to identify profitable trade setups on both the long and short sides. If drawn and analyzed correctly, price channels can provide precise entry, exit, stop-loss and profit-taking levels for all types of traders in all markets. However, price channels have their limits, and those who put too much faith in them can get burned.

A price channel combines an existing trendline with a second, parallel trendline so that when the lines are taken together, they fully contain the price fluctuations in the current leg of the move. The upper trendline connects significant highs of the move, and the lower trendline connects the lows of the move. These trendline levels represent areas where key demand (support) and supply (resistance) exist. An asset’s price will oscillate between these levels — the upper and lower trendlines — helping traders position their entries and risk-aware exits.

All else equal, buy entries tend to be more profitable when placed at the lower end of the channel, and sell entries tend to be more profitable when placed at the upper end. Of course, that thinking assumes the channel will hold. Likewise, traders can set stop-loss and profit-target orders in the vicinity of these established highs and lows to protect the bottom line or get the most out of a position.

“Stepping higher” (above) shows a typical price channel in the S&P 500 stock index. After setting a low of 1266 on June 8, 2012, the S&P 500 generated a series of higher highs and higher lows — the classic definition of an uptrend. Although relatively short in duration, this is a typical example of how price trends play out, with surges and retracements that, when taken together, result in a net move in a predominant direction. What also is clear is that channels aren’t always picture perfect. Highs and lows are fluid, and traders must be alert and flexible as channels develop.